One unexpected thing that could stop this rally

Now that it has broken through resistance at 1127 and 1130 on the Standard & Poor’s 500--and even briefly traded at the May high of 1150—what could prevent this rally from running straight through September (historically the worst month for stocks since 1928) into October (historically the second worst month for stocks) and then finishing 2010 with an end of the year rally?

In other words what should you be afraid of—and when.

One word. Are you listening, Benjamin? Earnings.

But probably not in the way—or with the timing--you would expect.

I’m not worried that unexpectedly bad earnings reports in the third quarter earnings season that gets underway on October 7 when PepsiCo (PEP) and Alcoa (AA) release numbers for the third quarter before the New York Stock Exchange opens and after the close, respectively, will reverse the rally. If that were the worry, I’d be expecting the rally to stall somewhere after earnings season started on the actual report of bad news.

Instead I’m worried that the stall will come before earnings season starts as investors who have made good profits in the September 1 rally decide to take profits rather than run the risk of possibly disappointing earnings. If I’m right about that timing, stocks might actually be ready to resume their rally around October 20—after a pre-earnings season dip—as earnings season ends. (Depending, of course, on what the polls say then about the November election. Polls that show a Republican runaway will leave my estimate of timing intact. Polls that show the Democrats closing could delay the start of any rally. Wall Street, if you haven’t noticed, is rooting—and voting with its campaign contributions--for a Republican victory in November.)

Let me explain the logic of that timing.

Assume that you’re an investor looking at gains like these (and I hope you are) from the August 26 (or thereabouts) low:

There’s even been a good rally in some of the market’s most beaten up stocks. Gulf of Mexico disaster stock Transocean (RIG) is up 17% from its August 26 low as of September 22.

So what are you thinking as earnings season approaches?

You’re thinking, I’ve had a big gain. Should I let it ride and bet on earnings season delivering an upside surprise?

And in many cases an earnings surprise is what you’ll need to lift shares after this rally. The consensus is, in many cases, already built into the stock price. After all Wall Street analysts have had months to tune and fine-tune their estimates. And in these days when investors can get analyst estimates from everybody from online brokers to CNBC to MSN Money and Yahoo Finance these numbers aren’t exactly secret

So “everybody” knows that Wall Street expects that Apple will report fiscal fourth quarter earnings of $3.97 a share on, my guess (since the company hasn’t confirmed a date) October 19. That would be earnings growth of 118% from the $1.82 in earnings per share reported for the fiscal fourth quarter of 2009.

Even for Apple significantly beating an earnings increase of 181% isn’t easy. That’s a bar that’s likely to make some investors nervous and willing to take profits before the actual earnings report.

It’s not just hot stocks like Apple that face this kind of hurdle. Analysts project Cummins, for example, will report earnings of $1.39 a share on October 26, up from 56 cents a share in the same quarter of 2009. That’s an Apple-like 148% increase.

It’s not that companies can’t achieve earnings increases like these. (In fact in the case of both Apple and Cummins, I think the odds are pretty good that they will.) It’s just that what we know of investor psychology, especially investor psychology after two bear markets in less than 10 years, argues that many investors won’t want to take the risk. Better profits in the hand than promises of future gains.

I think we’ll get a sense of how deep any pull back on earnings season jitters will be from earnings reports from the big banks that start arriving with JPMorgan Chase (JPM) on October 13 and continue through Goldman Sachs, (GS) and Bank of America (BAC) to Wells Fargo (WFC) on October 20. If these banks deliver solid earnings surprises, investors will get less nervous about what other companies will report and the pull back will be muted.

Unfortunately, the news isn’t likely to be any too good for big banks this quarter because trading volumes have been low this quarter and that will cut into revenue and earnings from trading. JPMorgan Chase, for example, has recently told analysts that trading revenue in the third quarter has been “not that dissimilar” to the second quarter. The bank reported a year-to-year drop in trading revenue in the second quarter.

Right now analyst estimates forecast pretty subdued growth in the third quarter. The consensus on JPMorgan Chase is for earnings to grow to 89 cents from 80 cents in the third quarter of 2009. That’s growth of just 11.25%.

I see two dangers here. First, there is the possibility that banks won’t surpass even these low growth estimates. Second, there’s the possibility that even meeting or slightly beating an 11.25% forecast won’t be enough for investors who saw a 53.5% earnings surprise above the consensus forecast for the second quarter.

Watch bank earnings and the reaction to them for clues to how big a pull back earnings worries are likely to cause as earnings season plays out.

What do you want to do now on the possibility of a pre-earnings season pull back?

You can, of course, ignore the whole thing. I don’t think the pullback is likely to exceed 100 points—that’s less than 10%--on the Standard & Poor’s 500. And I fully expect that we will see the rally resume in late October or early November.

You can sell now to take profits on some of winners. That, of course, carries the risk that I’m wrong and there won’t be a pullback at all. One way to reduce the risk of that is to sell winners from this rally that you don’t want to own in the next rally. BP (BP), for example, is up 7.6% from August 26. Do you want to own this oil stock, among all oil stocks, going forward?

And, finally, you can put some stops in place—either formally with your broker or mentally—that will trigger a sell if a stock drops more than you can stand. I think this is tricky in a pullback that isn’t likely to be very large—but it does give you safety if the pullback is larger than I now imagine. Where do you set stops? It depends on how big a loss you can stand—14%? 7%--before you get panicky and do something reckless (like selling it all). And it also depends on how disciplined you think you can be on buying back in. Setting a narrow stop—say a 7% drop—will only work if you’re capable of buying back in quickly once you sense the market has turned.

Whether you apply any of these strategies should also depend on how much cash you have in your portfolio. If you’ve got a lot of cash because you’ve been waiting for an opportunity to buy in, then raising more cash in a relatively small pullback isn’t a high priority. You’ll have enough to do putting that cash to work without increasing the amount that you want to invest. (So, for example, both my Jubak’s Picks portfolio and my new mutual fund Jubak Global Equity Fund (JUBAX) are flush with cash. Raising more by selling isn’t a high priority. But then I also expect a resumption of the rally after a relatively minor retreat.)